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Abstract

We extend a reduced form model for pricing pass-through mortgage backed securities
(MBS) and provide a novel hedging tool for investors in this market. To calculate the
price of an MBS, traders use what is known as option-adjusted spread (OAS). The
resulting OAS value represents the required basis points adjustment to reference curve
discounting rates needed to match an observed market price. The OAS suffers from
some drawbacks. For example, it remains constant until the maturity of the bond
(thirty years in mortgage-backed securities), and does not incorporate interest rate volatility. We suggest instead what we call dynamic option adjusted spread (DOAS), which allows investors in the mortgage market to account for both prepayment risk and changes of the yield curve.